Docsity Corporate Finance Inglese

Corporate Finance Inglese
Finanza Aziendale
Università degli Studi di Firenze (UNIFI)
26 pag.
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Corporate finance
Chapter 1:
The financial view of the firm:
- assets —> assets in place (existing investments, generate cashflows today, long lived
and short lived assets) and growth assets (excpected value that will be created by future
investments);
- liabilities —> debt (fixed claim on cash flows, little or no role in management) and equity
(residual claim on cash flows, significant role in management).
The first principle of finance is to maximize the value of the business (firm); we can reach
this object in different ways (3 principles):
- investment decision —> invest in assets that earn a return greater than the minimum
acceptable hurdle rate (E(R) > cost of capital);
- financing decision —> find the right kind of debt for your firm and the right mix of debt
and equity (mix able to minimize the cost of capital and so to maximize the value of the
business) to fund your operations;
- dividend decision —> if you cannot find investments that make your minimum
acceptable rate, return the cash to owners of your business.
Investment decision: the hurdle rate (soglia di rendimento) should reflect the riskiness of
the investment and the mix of debt and equity (struttura del finanziamento), used to fund it;
the return should reflect the magnitude and the timing of the cashflows as well as all side
effects.
Financing decision: the optimal mix of debt and equity maximizes firm value; the right kind
of debt matches the tenor of your assets.
Dividend decision: how much you can return depends upon current and potential
investment opportunities; how you choose to return cash to owners will depend whether
they prefer dividends or buybacks.
Finance is “common sense” and everything is based on the maximization of the firm value;
as a result of this singular objective we can:
- choose the right investment decision rule to use, given a menu of such rules;
- determine the right mix of debt and equity for a specific business;
- examine the right amount of cash that should be returned to the owners of a business
and the right amount to hold back as a cash balance.
—> cash flow
—> r = cost of capital
To maximize the firm value we can maximize the cash flows (selecting good projects —>
massimizzazione dei flussi di cassa attesi) or minimize the cost of capital (identifying the
optimal capital structure —> minimizzazione dei rischi). The maximization of the firm value
is achieved (raggiunto) with an active risk management.
The focus in corporate finance changes across the life cycle.
Every business has to make investment, financing and dividend decisions so corporate
finance is universal and the objective for all of the business is the same, maximizing value.
If you violate this principle you will pay a price: the strategies that violate the principle,
sooner or later, will blow up and create huge costs.
Another objective is the maximization of stock price (maximize stockholder wealth); when
the stock (stock = azioni) is traded and markets are viewed to be efficient, the objective is

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to maximize the stock price. Stock price is easily observable and constantly updated
(unlike other measures of performance, which may not be as easily observable, and
certainly not updated as frequently). If investors are rational, stock prices reflect the
wisdom (saggezza) of decisions, short term and long term, instantaneously.
The value of a firm is the present value of expected cash flows discounted at a rate
reflecting the risk of the investments and the financing mix used.
Chapters 3&4:
Since financial resources are finite, there is a hurdle that projects have to cross before
being deemed acceptable. This hurdle will be higher for riskier projects than for safer
projects. A simple
representation of the hurdle rate is:
Higher is the risk of the project higher is its risk premium.

The two basic questions that every risk and return model in finance tries to answer are:
- how do you measure risk?
- how do you translate this risk measure into a risk premium?
The risk in finance is represented by the Mean-Variance Framework; the variance of any
investment measures the
disparity between actual
and expected returns:
We can link risk and return (relazione tra rendimento di un titolo e sua rischiosità
sistematica) with the Capital Asset Pricing Model
(CAPM):
Rendimento atteso di un’attività i —> Ke =
Ke = cost of equity
E(Ri) = required return on common stock
Rf = risk-free rate of return
Beta = the beta measures the historical volatility of an individual stock’s return relative to a
stock market index. A beta greater than 1 indicates greater volatility (price movements)

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than the market (Beta > 1 —> attività con rischio superiore al mercato), while the reverse
would be true for a beta less than 1; Beta = 0 —> common stock with the same risk of the
market (titoli privi di rischio)
Beta = COV(im) / VAR(m)
Rm = return in the market as measured by an appropriate index
Rm - Rf = premium or excess return of the market versus the risk-free rate (since the
market is riskier than Rf, the assumption is that the expected Rm will be greater than Rf);
this is called equity risk premium (premio per il rischio di mercato)
Beta * (Rm - Rf) = expected return above the risk-free rate for the stock of company j,
given the level of risk
We start from the assumption that the investors are rational and they don't like risk (they
want to maximize return and minimize the risk); they have to be well diversified.
The marginal investor in a firm is the investor who is most likely to be the buyer or seller on
the next trade and to influence the stock price; in a stock, he has to own a lot of stock and
also trade a lot. The largest investor may not be the marginal investor, especially if he is a
founder/manager of the firm.
In all risk and return models in finance, we assume that the marginal investor is rational
and well diversified; the marginal investor could be an institutional investor.
Assuming diversification costs nothing (in terms of transactions costs), and that all assets
can be traded, the limit of diversification is to hold a portfolio of every single asset in the
economy (in proportion to market value). This portfolio is called the market portfolio. The
consequence of this is that an individual investors will adjust for risk, by adjusting their
allocations to this market portfolio and a riskless asset.
The risk of any asset is the risk that it adds to the market portfolio. Statistically, this risk
can be measured by how much an asset moves with the market (called the covariance).
Beta is a standardized measure of this covariance, obtained by dividing the covariance of
any asset with the market by the variance of the market (COV(im)/VAR(m)). It is a
measure of the non-diversificable risk for any asset can be measured by the covariance of
its returns with returns on a market index, which is defined to be the asset's beta.
The CAPM has some limitations:
- the model makes unrealistic assumption;
- the parameters of the model cannot be estimated precisely —> market index cannot be
exactly estimated;
- the model does not work well —> the model use only one factor, the beta of the market.
So we introduce another model, Arbitrage Pricing Model (APM). It is built on the premise
that two investments with the same exposure to risk should be priced to earn the same
expected returns. APM considers only the market risk. The arbitrage pricing model
requires estimates of each of the factor betas and factor risk premiums in addition to the
riskless rate. In practice, these are usually estimated using historical data on stocks and a
statistical technique called factor analysis. Intuitively, a factor analysis examines the
historical data looking for common patterns that affect broad groups of stocks (rather than
just one sector or a few stocks). It provides two output measures:
- it specifies the number of common factors that affected the historical data that it worked
on;

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- it measures the beta of each investment relative to each of the common factors, and
provides an estimate of the actual risk premium earned by each factor.

Rf = expected return on a zero-beta portfolio
E(Rj) = expected return on a portfolio with a factor beta of 1 for factor j and 0 for all other
factors
The CAPM, has survived as the default model for risk in equity valuation and corporate
finance. The alternative models (APM, Multifactor model..) have made inroads in
performance evaluation but not in prospective analysis because they (which are richer) do
a much better job than the CAPM in explaining past return, but their effectiveness drops off
when it comes to estimating expected future returns (because the models tend to shift and
change) and they are more complicated and require more information than the CAPM.
The CAPM yields (produce) the following expected return:

Expected return = risk free rate + beta * (expected return on the market portfolio - risk free
rate)
To use this model we need three inputs:
- the current risk free rate (tasso privo di rischio);
- the expected market risk premium (premio per il rischio);
- the beta of the asset being analyzed (misura del rischio remunerato —> stima del beta).
Risk free rate: this is a return of a common stock of which investor knows certainly the
expected return; the return is represented by the remuneration of the renounce to
immediate consumption.
To be risk free rate it has to be two conditions:
- it cannot be uncertainty on reinvestment rate (non deve esserci incertezza sui tassi di
reinvestimento);
- there must not be default risk (rischio d’insolvenza) —> this is the treasury bond issued
by a government with no default risk (government bonds). But it is possible that there is
no default free entity; in this case we have to adjust the local currency government
borrowing rate for default risk to get a riskless local currency rate (Example: in
November 2013, the Indian government rupee bond rate was 8.82%; the local currency
rating from Moody’s was Baa3 and the default spread for a Baa3 rated country bond
was 2.25%. Riskfree rate in Rupees = 8.82% - 2.25% = 6.57%).
There are three paths to estimate sovereign default spreads (rischio di insolvenza del
Paese):
- sovereign dollar or euro denominated bonds —> the difference between the interest rate
on a sovereign US $ bond, issued by the country, and the US treasury bond rate can be
used as the default spread (for example, in November 2013, the 10-year Brazil US $
bond, denominated in US dollars had a yield of 4.25% and the US 10-year T.Bond rate
traded at 2.75%, so default spread = 4.25% - 2.75% = 1.50%;
- CDS spreads —> obtain the default spreads for sovereigns in the CDS market;
- average spread —> if you know the sovereign rating for a country you can estimate the
default spread based on the rating.

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Expected market risk premium: the risk premium is the premium that investors demand for
investing in an average risk investment, relative to the risk free rate; this premium should
be:
- greater than zero;
- increase with the risk aversion of the investors in that market;
- increase with the riskiness of the average risk investment.
There are three approach to estimate equity risk premium:
- survey investors on their desired risk premiums and use the average premium form
these surveys (metodo dei sondaggi) —> surveying all investors in a market place is
impractical; however, you can survey a few individuals and use these results. The
survey results are extremely volatile and they tend to be short term;
- assume that the actual premium delivered over long time periods is equal to the
expected premium (use historical data —> metodo dei premi storici) —> this is the
default approach used by most to arrive at the premium to use in the model;
- estimate the implied premium in today’s asset prices (metodo dei premi impliciti).
Historical data for markets outside the United States is available for much shorter time
periods; the problem is even greater in emerging markets. The historical premiums that
emerge from this data reflects this data problem and there is much greater error
associated with the estimates of the premiums.
Three ways to estimate country equity risk premiums for other markets:
- default spread on country bond —> in this approach, the country equity risk premium is
set equal to the default spread of the bond issued by the country (but only if it is
denominated in a currency where a default free entity exists)

- relative equity market approach —> the country equity risk premium is based upon the
volatility of the market in
question relative to
U.S market
default spread corrected by relative standard deviation of equity and bond markets —>
while default risk premiums and equity risk premiums are highly correlated, one would
expect equity spreads to be higher than debt spreads. This approach multiply the bond
default spread by the relative volatility of stock and bond prices in that market
There are three approach to pass from country equity risk premiums to corporate equity
risk premiums:

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- approach 1 —> every company in the country is equally exposed to country risk; in this
case:
E(Return) = Riskfree Rate + Country ERP+ Beta (US premium)
This is what you are assuming when you use te local Government’s dollar borrowing
rate as your risk free rate;
- approach 2 —> a company’s exposure to country risk is similar to its exposure to other
market risk; E(Return) = Riskfree Rate + Beta (US premium + Country ERP);
- approach 3 —> treat country risk as a separate risk factor and allow firms to have
different exposure to country risk;
E(Return) = Riskfree Rate + Beta (US premium) + Lambda (Country ERP)
The determinants to estimate the company exposure to country risk are:

- source of revenues —> other things remaining equal, a company should be more
exposed to risk in a country if it generates more of its revenues from that country. A
Brazilian firm that generates the bulk of its revenues in Brazil should be more exposed
to country risk than one that generates a smaller percent of its business within Brazil;
- manufacturing facilities —> other things remaining equal, a firm that has all of its
production facilities in Brazil should be more exposed to country risk than one which has
production facilities spread over multiple countries. The problem will be accented for
companies that cannot move their production facilities (mining and petroleum
companies, for instance);
- use of risk management products —> companies can use both options/futures markets
and insurance to hedge some or a significant portion of country risk.
Example: assume that the beta for Embraer is 1.07, and that the riskfree rate used is
4.29%. Also assume that the risk premium for the US is 4.82% and the country risk
premium for Brazil is 7.89%.
Approach 1: Assume that every company in the country is equally exposed to country risk
—> E(Return) = 4.29% + 1.07 (4.82%) + 7.89% = 17.34%
Approach 2: Assume that a company’s exposure to country risk is similar to its exposure
to other market risk —> E(Return) = 4.29 % + 1.07 (4.82%+ 7.89%) = 17.89%
ERP: If you can observe what investors are willing to pay for stocks, you can back out an
expected return from that price and an implied equity risk premium.

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A way of estimating Equity Risk Premium for countries:

- step 1 —> estimate an equity risk premium for a mature market. If your preference is for
a forward looking, updated number, you can estimate an implied equity risk premium for
the US (assuming that you buy into the contention that it is a mature market);
- step 2 —> come up with a generic and measurable definition of a mature market;
- step 3 —> estimate the additional risk premium that you will charge for markets that are
not mature. We have two choices: the default spread for the country, estimated based
either on sovereign ratings or the CDS market; a scaled up default spread, where you
adjust the default spread upwards for the additional risk in equity markets.
Estimating Beta: the standard procedure to estimate betas is to regress stock returns (Rj)
against market returns (Rm) —> Rj = a + b * Rm, where a is the intercept and b is the
slope of the regression.
The slope of the regression corresponds to the beta of the stock and measures the
riskiness of the stock.
R^2 —> indicates how much variance of the return of a stock is explained by the variance
of the market. It provides an estimate of the proportion of the risk (variance) of a firm that
can be attributed to market risk.
The total risk is 1 and it is divided in market risk and specific risk; so (1-R^2) is the firm
specific risk (the firm-specific risk is diversifiable and will not be rewarded).
The intercept of the regression provides a simple measure of performance during the
period of the regression, relative to the capital asset pricing model.
CAPM —> Rj = Rf+ b (Rm - Rf) = Rf (1-b) + b * Rm
Regression equation —> Rj = a + b * Rm
We can see three different cases:
- if a > Rf (1-b) —> stock did better than expected during regression;
- if a = Rf (1-b) —> stock did as well as expected during regression;
- if a < Rf (1-b) —> stock did worse than expected during regression.
The difference between the intercept and Rf (1-b) is Jensen's alpha. If it is positive, your
stock did perform better than expected during the period of the regression.
Now we have seen the regression beta, that is one of the three approach to estimate beta.
Another approach, the bottom-up beta, is based on some determinant of beta:

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- industry effects —> the beta value for a firm depends upon the sensitivity of the demand
for its products and services and of its costs to macroeconomic factors that affect the
overall market;
- degree of operating leverage —> operating leverage refers to the proportion of the total
costs of the firm that are fixed. Other things remaining equal, higher operating leverage
results in greater earnings variability which in turn results in higher betas.
EBIT Variability Measure = % Change in EBIT / % Change in Revenues ;
- financial leverage —> as firms borrow, they create fixed costs (interest payments) that
make their earnings to equity investors more volatile.
The bottom up beta can be estimated by doing the following:
- find out the businesses that a firm operates in;
- find the unlevered betas of other firms in these businesses;
- take a weighted (by sales or operating income) average of these unlevered betas;
- lever up using the firm’s debt/equity ratio.
The bottom up beta is a better estimate than the regression beta because the standard
error of the beta estimate will be much lower and because the betas can reflect the current
(and even expected future) mix of businesses that the firm is in rather than the historical
mix.
Equity betas and Leverage:

The beta of equity alone can be written as a function of the unlevered beta and the debt
equity ratio:
βL = levered or equity betaL = levered or equity beta
βL = levered or equity betaU = unlvered or asset beta
t = marginal tax rate
D = market value of debt
E = market value of equity
The Beta of cash is zero (no market risk); since the market betas incorporate the cash
position of the firms, we need to adjust as
follows:
Firm value = Market Capital + Market Value of debt = E + D

Market Capital = E = Current Stock Price * Number of share outstanding
Enterprise Value = Firm Value - Cash
To convert a discount rate in one currency to another, all you need are expected inflation
rates in the two currencies:
About estimating Betas for Non-Traded Assets (private firms), the conventional
approaches of estimating betas from regressions do not work for assets that are not
traded; there are no stock prices or historical returns that can be used to compute

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regression betas. There are two ways in which betas can be estimated for non traded
assets: using comparable firms or, if there aren’t comparables, using accounting earnings
(accounting betas are computed by regressing accounting earnings changes at the firm
against changes in earnings at the S&P 500). There are two problems with accounting
betas:
- earnings tend to be smoothed out;
- you will not have very many observations in your regression: most private firms have
financials only once a year. For a firm that has been in existence just a few years, the
sample size will be extremely small.
If the investors are not diversified (the owners of most private firms are not diversified),
beta (that measures the risk added on to a diversified portfolio) could be not a good
estimator; so it could be not an adequate measure of risk for a private firm because it
could under estimate the cost of equity for the private firm.
The solution of this problem is the total risk. We adjust the beta to reflect total risk rather
than market risk; this adjustment is a relatively simple one, since the R squared of the
regression measures the proportion of the risk that is market risk (R = correlation with the
market):
Total Beta = Market Beta / Correlation of the sector with the market
Cost of capital: the cost of capital is a composite cost to the firm of raising financing to fund
its projects; in addition to equity, firms can raise capital from debt and debt should include
any interest-bearing liability (whether short term or long term) and any lease obligation
(whether operating or capital).
Cost of capital —>
Cost of debt (Kd) —> Kd = (risk free rate + default risk premium) * (1-tc)
If the firm has bonds outstanding, and the bonds are traded, the yield to maturity on a
long-term, straight (no special features) bond can be used as the interest rate. If the firm is
rated, use the rating and a typical default spread on bonds with that rating to estimate the
cost of debt.
If the firm is not rated:
- and it has recently borrowed long term from a bank, use the interest rate on the
borrowing;
- estimate a synthetic rating for the company, and use the synthetic rating to arrive at a
default spread and a cost of debt.
The cost of debt has to be estimated in the same currency as the cost of equity and the
cash flows in the
valuation.
The rating for a firm can be estimated using the financial characteristics of the firm. In its
simplest form, we can use just the interest coverage ratio:
Interest Coverage Ratio = EBIT / Interest Expenses
EBIT = operating income

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The interest coverage ratio is how much of operating income is not give to the bank for the
interest expenses (if I have an interest coverage ratio of 20 it means that I have operating
income 20 times higher than the interest that I have to give to the bank). Higher is my
interest coverage ratio higher is my class of rating.
Cost of hybrids: there are two kinds of hybrids:

- preferred stock (azioni di risparmio) —> shares some of the characteristics of debt (the
preferred dividend is pre-specified at the time of the issue and is paid out before
common dividend) and some of the characteristics of equity (the payments of preferred
dividend are not tax deductible). If preferred stock is viewed as perpetual, the cost of
preferred stock can be written as follows:
kps = Preferred Dividend per share/ Market Price per preferred share;
- convertible debt —> this is part debt (the bond part) and part equity (the conversion
option); it is best to break it up into its component parts and eliminate it from the mix
altogether.
The weights used in the cost of capital computation should be market values; there are
three specious arguments used against market value:
- book value is more reliable than market value because it is not as volatile; while it is true
that book value does not change as much as market value, this is more a reflection of
weakness than strength;
- using book value rather than market value is a more conservative approach to
estimating debt ratios; for most companies, using book values will yield a lower cost of
capital than using market value weights;
- since accounting returns are computed based upon book value, consistency requires
the use of book value in computing cost of capital; while it may seem consistent to use
book values for both accounting return and cost of capital calculations, it does not make
economic sense.
Either the cost of equity or the cost of capital can be used as a hurdle rate, depending
upon whether the returns measured are to equity investors or to all claimholders on the
firm (capital):
- if returns are measured to equity investors, the appropriate hurdle rate is the cost of
equity;
- if returns are measured to capital (or the firm), the appropriate hurdle rate is the cost of
capital.
Chapter 5:
Now we are going to talk about the measuring investment returns that could be based on
earning or on cash flows.
Earning measurements are based on:
- accrual accounting (bilancio di competenza) —> show revenues when products and
services are sold or provided, not when they are paid for; show expenses associated
with these revenues rather than cash expenses;
- operating versus capital expenditures —> only expenses associated with creating
revenues in the current period should be treated as operating expenses. Expenses that
create benefits over several periods are written off over multiple periods (as depreciation
or amortization).
To get from accounting earnings to cash flows:
- you have to add back non-cash expenses (like depreciation);

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- you have to subtract out cash outflows which are not expensed (such as capital
expenditures);
- you have to make accrual revenues and expenses into cash revenues and expenses (by
considering changes in working capital).
It is better to use cash flows rather than earnings; we have to use incremental cash flows
relating to the investment decision (cashflows that occur as a consequence of the
decision, rather than total cash flows) and time weighted returns (value cash flows that
occur earlier more than cash flows that occur later).
An investment/project can range the spectrum from big to small, money making to cost
saving:
- major strategic decisions to enter new areas of business or new markets;
- acquisitions of other firms are projects as well, notwithstanding attempts to create
separate sets of rules for them;
- decisions on new ventures within existing businesses or markets;
- decisions that may change the way existing ventures and projects
are run;
- decisions on how best to deliver a service that is necessary for the business to run
smoothly.
Put in broader terms, every choice made by a firm can be framed as an investment.
FCFF = EBIT (1-t) + DEPRECIATION - NONCASH WORKING CAPITAL VARIATION -

CAPITAL EXPENDITURES
FCFE = NET INCOME + DEPRECIATION - NON CASH WORKING CAPITAL VARIATION

- CAPITAL EXPENDITURES - RETIREMENT OF BONDS, REPURCHASE OF COMMON
STOCK + SALES OF BOND, COMMON STOCK, PREFERRED STOCK
Net Present Value (NPV): the net present value is the sum of the present values of all
cash flows from the project (including initial

investment).
We accept an investment if NPV > 0
Internal Rate of Return (IRR): the internal rate of return is the discount rate that sets the
net present value equal to zero. It is the percentage rate of return, based upon incremental
time-weighted cash flows. We accept an investment if IRR > hurdle rate (if we use FCFF
we have to compare IRR with WACC; if we use FCFE we have to compare IRR with Ke).
The IRR and the NPV will yield similar results most of the time, though there are
differences between the two approaches that may cause project rankings to vary
depending upon the approach used. They can yield different results, especially why
comparing across projects because:

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- a project can have only one NPV, whereas it can have more than one IRR;
- the NPV is a dollar surplus value, whereas the IRR is a percentage measure of return.
The NPV is therefore likely to be larger for “large scale” projects, while the IRR is higher
for “small-scale” projects;
- the NPV assumes that intermediate cash flows get reinvested at the hurdle rate, which
is based upon what you can make on investments of comparable risk, while the IRR
assumes that intermediate cash flows get reinvested at the IRR.
The exchange rate risk should be diversifiable risk (and hence should not command a
premium) if the company has projects in a large number of countries or the investors in the
company are globally diversified.
The same diversification argument can also be applied against some political risk, which
would mean that it too should not affect the discount rate. However, there are aspects of
political risk especially in emerging markets that will be difficult to diversify and may affect
the cash flows, by reducing the expected life or cash flows on the project.
Capital expenditures are not treated as accounting expenses but they do cause cash
outflows and it can generally be categorized into two groups:
- new (or growth) capital expenditures are capital expenditures designed to create new
assets and future growth;
- maintenance capital expenditures refer to capital expenditures designed to keep existing
assets.
Both initial and maintenance capital expenditures reduce cash flows. The need for
maintenance capital expenditures will increase with the life of the project. In other words, a
25-year project will require more maintenance capital expenditures than a 2- year project.
Non-cash working capital = Inventory + Accounts Receivable - Accounts Payable
Intuitively, money invested in inventory or in accounts receivable cannot be used

elsewhere. It, thus, represents a drain on cash flows.To the degree that some of these
investments can be financed using supplier credit (accounts payable), the cash flow drain
is reduced.
Investments in working capital are thus cash outflows:
- any increase in working capital reduces cash flows in that year;
- any decrease in working capital increases cash flows in that year.
The failure to consider working capital in a capital budgeting project will overstate cash
flows on that project and make it look more attractive than it really is. Other things held
equal, a reduction in working capital requirements will increase the cash flows on all
projects for a firm.
A sunk cost is any expenditure that has already been incurred and cannot be recovered;
when analyzing a project, sunk costs should not be considered since they are not
incremental.
About allocated costs, firms allocate costs to individual projects from a centralized pool
(such as general and administrative expenses) based upon some characteristic of the
project (sales is a common choice, as is earnings). For large firms, these allocated costs
can be significant and result in the rejection of projects.
To the degree that these costs are not incremental (and would exist anyway), this makes
the firm worse off. Thus, it is only the incremental component of allocated costs that should
show up in project analysis.

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Incremental cash flows in the earlier years are worth more than incremental cash flows in
later years. In fact, cash flows across time cannot be added up. They have to be brought
to the same point in time before aggregation.
This process of moving cash flows through time is:
- discounting (attualizzazione), when future cash flows are brought to the present;
- compounding (capitalizzazione), when present cash flows are taken to the future.
In a project with a finite and short life, you would need to compute a salvage value, which
is the expected proceeds from selling all of the investment in the project at the end of the
project life. It is usually set equal to book value of fixed assets and working capital.
In a project with an infinite or very long life, we compute cash flows for a reasonable
period, and then compute a terminal value for this project, which is the present value of all
cash flows that occur after the estimation period ends. Assuming the project lasts forever
and that cash flows after year 10 grow 2% (the inflation rate) forever, the present value at
the end of year 10 of cash flows after that can be written as:
Terminal Value in year10 = CF in year11 / (Cost of Capital- Growth Rate)
= 715 (1.02) /(.0846-.02) = $ 11,275 million
About the consistency rule for cash flows, the cash flows on a project and the discount rate
used should be defined in the same terms: if cash flows are in dollars, the discount rate
has to be a dollar discount rate; if the cash flows are nominal (real), the discount rate has
to be nominal (real). If consistency is maintained, the project conclusions should be
identical, no matter what cash flows are used.
The investment analysis can be done entirely in equity terms, as well. The returns,
cashflows and hurdle rates will all be defined from the perspective of equity investors.
If using accounting returns, Return will be Return on Equity:
(ROE) = Net Income/BV of Equity, ROE has to be greater than cost of equity
If using discounted cashflow models, cashflows will be cashflows after debt payments to
equity investors and hurdle rate will be cost of equity.
Chapter 6:
In all of the examples we have used so far, the investments that we have analyzed have
stood alone. In the real world, most investments are not independent. Taking an
investment can often mean rejecting another investment at one extreme (mutually
exclusive) to being locked in to take an investment in the future (pre-requisite).
More generally, accepting an investment can create side costs for a firm’s existing
investments in some cases and benefits for others.
In some cases, though, firms may have to choose between investments because:
- they are mutually exclusive —> taking one investment makes the other one redundant
because they both serve the same purpose;
- the firm has limited capital and cannot take every good investment (i.e., investments
with positive NPV or high IRR).
Using the two standard discounted cash flow measures, NPV and IRR, can yield different
choices when choosing between investments.
When comparing and choosing between investments with the same lives, we can:
- compute the accounting returns (ROC, ROE) of the investments and pick the one with
the higher returns;
- compute the NPV of the investments and pick the one with the higher NPV;
- compute the IRR of the investments and pick the one with the higher IRR.
While it is easy to see why accounting return measures can give different rankings (and
choices) than the discounted cash flow approaches, you would expect NPV and IRR to

14
yield consistent results since they are both time-weighted, incremental cash flow return
measures.
If a business has limited access to capital, has a stream of surplus value projects and
faces more uncertainty in its project cash flows, it is much more likely to use IRR as its
decision rule; if a business has substantial funds on hand, access to capital, limited
surplus value projects, and more certainty on its project cash flows, it is much more likely
to use NPV as its decision rule.
The problem with the NPV rule, when there is capital rationing, is that it is a dollar value. It
measures success in absolute terms; the NPV can be converted into a relative measure by
dividing by the initial investment. This is called the profitability index.
Profitability Index (PI) = NPV/Initial Investment
The NPV rule assumes that intermediate cash flows on the project get reinvested at the
hurdle rate (which is based upon what projects of comparable risk should earn).
The IRR rule assumes that intermediate cash flows on the project get reinvested at the
IRR. Implicit is the assumption that the firm has an infinite stream of projects yielding
similar IRRs. In conclusion when the IRR is high (the project is creating significant surplus
value) and the project life is long, the IRR will overstate the true return on the project.
One of the solution to reinvestment rate problem is the Modified Internal
Rate of
Return
(MIRR):
MIRR—>
NPV and IRR can be different even if projects have the same lives. A project can have
only one NPV, whereas it can have more than one IRR. The NPV is a dollar surplus value,
whereas the IRR is a percentage measure of return. The NPV is therefore likely to be
larger for “large scale” projects, while the IRR is higher for “small-scale” projects.
The NPV assumes that intermediate cash flows get reinvested at the “hurdle rate”, which
is based upon what you can make on investments of comparable risk, while the IRR
assumes that intermediate cash flows get reinvested at the “IRR”.
NPVs cannot be compared when projects have different lives; to compare the NPV, we
have to replicate the projects till they have the same life or to convert the net present
values into annuities. The IRR is unaffected by project life; we can choose the project with
the higher IRR.
We can compare projects with different lives by converting their net present values into
equivalent annuities. These equivalent annuities can be compared legitimately across

15
projects with different lives. The NPV of any project can be converted into an annuity using
the following
calculation.
r = project discount rate

n = project lifetime
Note that the NPV of each project is converted into an annuity using that project’s life and
discount rate and that the second term in the equation is the annuity factor. Thus, this
approach is flexible enough to use on projects with different discount rates and lifetimes.
Most projects considered by any business create side costs and benefits for that business.
The side costs include the costs created by the use of resources that the business already
owns (opportunity costs) and lost revenues for other projects that the firm may have. The
benefits that may not be captured in the traditional capital budgeting analysis include
project synergies (where cash flow benefits may accrue to other projects) and options
embedded in projects (including the options to delay, expand or abandon a project). The
returns on a project should incorporate these costs and benefits.
An opportunity cost arises when a project uses a resource that may already have been
paid for by the firm. When a resource that is already owned by a firm is being considered
for use in a project, this resource has to be priced on its next best alternative use, which
may be:
- a sale of the asset, in which case the opportunity cost is the expected proceeds from the
sale, net of any capital gains taxes;
- renting or leasing the asset out, in which case the opportunity cost is the expected
present value of the after-tax rental or lease revenues;
- use elsewhere in the business, in which case the opportunity cost is the cost of
replacing it.
There also may be positive consequences when there are more than one project; it is the
case of project synergies. A project may provide benefits for other projects within the firm.
In investment analysis, however, these synergies are either left unquantified and used to
justify overriding the results of investment analysis. If synergies exist and they often do,
these benefits have to be valued and shown in the initial project analysis.
Another thing we have to consider when there are more than one project are the project
options. One of the limitations of traditional investment analysis is that it is static and does
not do a good job of capturing the options embedded in investment; there are 3 kinds of
options:
- the first of these options is the option to delay taking a project, when a firm has exclusive
rights to it, until a later date (possibilità di ritardare l'assunzione di un progetto, quando
un'impresa ha diritti esclusivi su di esso);
- the second of these options is taking one project may allow us to take advantage of
other opportunities (projects) in the future (sfruttare altre opportunità in futuro);
- the last option that is embedded in projects is the option to abandon a project, if the
cash flows do not measure up.
These options all add value to projects and may make a bad project into a good one.
The option to delay (ritardare): when a firm has exclusive rights to a project or product for
a specific period, it can delay taking this project or product until a later date. A traditional

16
investment analysis just answers the question of whether the project is a “good” one if
taken today. The rights to
a “bad” project can
still have value.
The option to expand/take other projects: taking a project today may allow a firm to
consider and take other valuable projects in the future. Thus, even though a project may
have a negative NPV, it may be a project worth taking if the option it provides the firm (to
take other projects in the future) has a more than compensating value.
The option to abandon: a firm may sometimes have the option to abandon a project, if the
cash flows do not measure up to expectations. If abandoning the project allows the firm to
save itself from further
losses, this option can
make a project more
valuable.
While much of our discussion has been focused on analyzing new investments, the
techniques and principles enunciated apply just as strongly to existing investments. For
existing or past investment, we can try to address one of two questions:
- post-mortem —> we can look back at existing investments and see if they have created
value for the firm;

17
- what next —> we can use the tools of investment analysis to see whether we should
keep, expand or abandon existing investments.
Post mortem: the actual cash flows from an investment can be greater than or less than
originally forecast for a number of reasons but all these reasons can be categorized into
two groups:
- chance (opportunità) —> the nature of risk is that actual outcomes can be different from
expectations. Even when forecasts are based upon the best of information, they will
invariably be wrong in hindsight because of unexpected shifts in both macro (inflation,
interest rates, economic growth) and micro (competitors, company) variables;
- bias (propensione) —> if the original forecasts were biased, the actual numbers will be
different from expectations. The evidence on capital budgeting is that managers tend to
be over-optimistic about cash flows and the bias is worse with over-confident managers.
While it is impossible to tell on an individual project whether chance or bias is to blame,
there is a way to tell across projects and across time. If chance is the culprit (colpevole),
there should be symmetry in the errors – actuals should be about as likely to beat
forecasts as they are to come under forecasts. If bias is the reason, the errors will tend to
be in one direction.
What can we do next?:
- liquidate the project if NPV < 0;
- terminate the project if NPV < Salvage Value;
- divest (abbandonare) the project if NPV < Divestiture Value (the today value if we
dismiss the project);
- continue the project if NPV > Divestiture Value.
Chapter 8:
There are only two ways in which a business can raise money:
- debt —> the essence of debt is that you promise to make fixed payments in the future
(interest payments and repaying principal). If you fail to make those payments, you lose
control of your business;
- equity —> with equity, you do get whatever cash flows are left over after you have made
debt payments.
When we decide to raise financing for a business we have to find an optimal mix of debt
and equity to maximize the shareholders value.
There are some different approaches to reach the optimal capital structure:
- the cost of capital approach —> the optimal debt ratio is the one that minimizes the cost
of capital for a firm; we can use this approach when there aren’t bankruptcy costs (costi
di insolvenza);

18
- the enhanced cost of capital approach —> the optimal debt ratio is the one that
generates the best combination of (low) cost of capital and (high) operating income;
- the adjusted present value approach —> the optimal debt ratio is the one that
maximizes the overall value of the firm;
- the sector approach —> the optimal debt ratio is the one that brings the firm closes to its
peer group in terms of financing mix;
- the life cycle approach —> the optimal debt ratio is the one that best suits where the firm
is in its life cycle.
The cost of capital approach: the value of a firm is the present value of cash flows to the
firm, discounted back at the cost of
capital:
If the cash flows to the firm are held constant and the cost of capital is minimized, the
value of the firm will maximized.
The cost of capital depends on the portion of debt and equity (Kd < Ke, debt costs lower
than equity) and it may increase or decrease; the benefits of debt is up to a point and this
point represents the optimal capital structure (in this point the cost of capital is the lowest
and the value of the firm is maximized).
To identify the optimal capital structure we have to:
- estimate the cost of equity at different levels of debt —> equity will become riskier, beta
will increase and the cost of equity will increase; estimation will use levered beta
calculation;
- estimate the cost of debt at different levels of debt —> default risk will go up and bond
ratings will go down as debt goes up, cost of debt will increase; to estimating bond
ratings, we will use the interest coverage ratio (EBIT/Interest expense);
- estimate the cost of capital at different levels of debt;
- calculate the effect on firm value and stock price.
We can pass from firm value to value per share; because the increase in value accrues
entirely to stockholders, we can estimate the increase in value per share by dividing by the
total number of shares outstanding. Implicit in this computation is the assumption that the
increase in firm value will be spread evenly across both the stockholders who sell their
stock back to the firm and those who do not and that is why we term this the “rational”
solution, since it leaves investors indifferent between selling back their shares and holding
on to them.
When we have a buyback price, we start with the buyback price and compute the number
of shares outstanding after the buyback:
Increase in Debt = Debt at optimal – Current Debt
Shares after buyback = Shares before - (Increase in Debt / Share Price)
Then we compute the equity value after the recapitalization, starting with the enterprise
value at the optimal, adding back cash and subtracting out the debt at the optimal:
Equity value after buyback = Optimal Enterprise value + Cash – Debt
After we divide the equity value after the buyback by the post-buyback number of shares.
Value per share after buyback = Equity value after buyback/ Number of shares after
buyback
We also have to see how capital structure changes the operating income.

19
The downside risk:
- sensitivity to assumptions —> “What if” analysis (the optimal debt ratio is a function of
our inputs on operating income, tax rates and macro variables; we could focus on one or
two key variables – operating income is an obvious choice – and look at history for
guidance on volatility in that number and ask what if questions) or “economic scenario”
approach (we can develop possible scenarios, based upon macro variables, and
examine the optimal debt ratio under each one; for instance, we could look at the
optimal debt ratio for a cyclical firm under a boom economy, a regular economy and an
economy in recession);
- constraint on Bond Ratings / Book Debt Ratios —> alternatively, we can put constraints
on the optimal debt ratio to reduce exposure to downside risk. Thus, we could require
the firm to have a minimum rating, at the optimal debt ratio or to have a book debt ratio
that is less than a “specified” value.
The second potential change it could happen is the constraint on ratings; management
often specifies a desired rating below which they do not want to fall. The rating constraint
is driven by three factors:
- it is one way of protecting against downside risk in operating income (so do not do both);
- a drop in ratings might affect operating income;
- there is an ego factor associated with high ratings.
Every rating constraint has a cost; the cost of a rating constraint is the difference between
the unconstrained value and the value of the firm with the constraint. Managers need to be
made aware of the costs of the constraints they impose.
The cost of capital approach has some limitations:
- it is static —> the most critical number in the entire analysis is the operating income; if
that changes, the optimal debt ratio will change;
- it ignores indirect bankruptcy costs —> the operating income is assumed to stay fixed as
the debt ratio and the rating changes;
- Beta and ratings —> it is based upon rigid assumptions of how market risk and default
risk get borne as the firm borrows more money and the resulting costs.
Enhanced cost of capital approach: to overcame these limitations we can use the
enhanced cost of capital approach:
- distress cost affected operating income —> the indirect costs of bankruptcy are built into
the expected operating income; as the rating of the firm declines, the operating income
is adjusted to reflect the loss in operating income that will occur when customers,
suppliers and investors react;
- dynamic analysis —> rather than look at a single number for operating income, you can
draw from a distribution of operating income (thus allowing for different outcomes).
We can extend this approach to analyze financial service firms (a bank for example);
interest coverage ratio spreads, which are critical in determining the bond ratings, have to
be estimated separately for financial service firms; applying manufacturing company
spreads will result in absurdly low ratings for even the safest banks and very low optimal
debt ratios. It is difficult to estimate the debt on a financial service company’s balance
sheet. Given the mix of deposits, repurchase agreements, short-term financing, and other
liabilities that may appear on a financial service firm’s balance sheet, one solution is to
focus only on long term debt, defined tightly, and to use interest coverage ratios defined
using only long term interest expenses. Financial service firms are regulated and have to
meet capital ratios that are defined in terms of book value. If, in the process of moving to
an optimal market value debt ratio, these firms violate the book capital ratios, they could
put themselves in jeopardy.

20
There are four determinants of the optimal debt ratio:
- the marginal tax rate —> the primary benefit of debt is a tax benefit; the higher the
marginal tax rate, the greater the benefit to borrowing;
- pre-tax cash flow return —> higher cash flows, as a percent of value, give you a higher
debt capacity, though less so in emerging markets with substantial country risk;
- operating risk —> firms that face more risk or uncertainty in their operations (and more
variable operating income as a consequence) will have lower optimal debt ratios than
firms that have more predictable operations; operating risk enters the cost of capital
approach in two places: the unlevered Beta (firms that face more operating risk will tend
to have higher unlevered betas) and the bond ratings (firms that face more risk in
operations will have lower ratings);
- the macro determinant —> for this determinant is important to consider the equity risk
premium and the Bond default spread.
Adjusted present value approach: the third way to determine the optimal capital structure
is the APV approach (adjusted present value approach); here the value of the firm is
written as the sum of the value of the firm without debt (the unlevered firm) and the effect
of debt on firm value:
Firm Value = Unlevered Firm Value + (Tax Benefits of Debt - Expected Bankruptcy Cost
from the Debt)
Tax benefits each year = Pre-tax Kd * $D * tax
PV of tax benefits in perpetuity = (Pre-tax Kd * $D * tax) / Kd = $D * tax
Exp. Bankruptcy cost = Probability of Default * (PV of direct and indirect cost of
bankruptcy)
The optimal dollar debt level is the one that maximizes firm value. To implement the APV
approach we have to:
- estimate the unlevered firm value; this can be done in one of two ways: estimating the
unlevered beta, a cost of equity based upon the unlevered beta and valuing the firm
using this cost of equity (which will also be the cost of capital, with an unlevered firm).
Alternatively, Unlevered Firm Value = Current Market Value of Firm - Tax Benefits of
Debt (Current) + Expected Bankruptcy cost from Debt;
- estimate the tax benefits at different levels of debt —> the simplest assumption to make
is that the savings are perpetual, in which case Tax benefits = Dollar Debt * Tax Rate;
- estimate a probability of bankruptcy at each debt level, and multiply by the cost of
bankruptcy (including both direct and indirect costs) to estimate the expected bankruptcy
cost.
To estimate the expected bankruptcy cost we have to consider the probability of
bankruptcy and the cost of bankruptcy. For the probability we have to estimate the
synthetic rating that the firm will have at each level of debt and then estimate the
probability that the firm will go bankrupt over time, at that level of debt; for the cost, the
direct bankruptcy cost is the easier component (it is generally between 5-10% of firm
value, based upon empirical studies), the indirect bankruptcy cost is much tougher. It
should be higher for sectors where operating income is affected significantly by default risk
(like airlines) and lower for sectors where it is not (like groceries).
Relative analysis: the “safest” place for any firm to be is close to the industry average.
Subjective adjustments can be made to these averages to arrive at the right debt ratio:
- Higher tax rates —> Higher debt ratios (Tax benefits);
- Lower insider ownership —> Higher debt ratios (Greater discipline);
- More stable income —> Higher debt ratios (Lower bankruptcy costs);

21
- More intangible assets —> Lower debt ratios (More agency problems)
It is also possible to apply the regression methodology in this way:
- run a regression of debt ratios on the variables that you believe determine debt ratios in
the sector. For example, Debt Ratio = a + b (Tax rate) + c (Earnings Variability) + d
(EBITDA/Firm Value). Check this regression for statistical significance (t statistics) and
predictive ability (R squared);
- estimate the values of the proxies for the firm under consideration; plugging into the
cross sectional regression, we can obtain an estimate of predicted debt ratio;
- compare the actual debt ratio to the predicted debt ratio.
Chapter 9:
We will consider how firms should choose the right financing vehicle for raising capital for
their investments. We argue that a firm’s choice of financing should be determined largely
by the nature of the cash flows on its assets. Matching financing choices to asset
characteristics decreases default risk for any given level of debt and allows the firm to
borrow more.
At the end of the analysis of financing mix (using whatever tool or tools you choose to
use), you can come to one of three conclusions:
- the firm has the right financing mix;
- it has too little debt (it is under levered);
- it has too much debt (it is over levered).
The next step in the process is deciding how much quickly or gradually the firm should
move to its optimal and, assuming that it does, the right kind of financing to use in making
this adjustment.
There are some ways to change debt ratio quickly:
- to decrease the debt ratio —> the firm can sell operating assets and use cash to pay
down debt or it can issue new stock to retire debt or get debt holders to accept equity in
the firm;
- to increase the debt ratio —> the firm can sell operating assets and use cash to buyback
stock or pay special dividend or it can borrow money and buyback stock or pay a large
special dividend.
To change debt ratios over time, you use the same mix of tools that you used to change
debt ratios gradually:
- dividends and stock buybacks —> dividends and stock buybacks will reduce the value
of equity;
- debt repayments —> will reduce the value of debt.
The complication of changing debt ratios over time is that firm value is itself a moving
target.
The objective in designing debt is to make the cash flows on debt match up as closely as
possible with the cash flows that the firm makes on its assets. By doing so, we reduce our
risk of default, increase debt capacity and increase firm value.
To choose the right financing instruments, we lay out a sequence of steps by which a firm
can choose it:
- examination of the cash flow characteristics of the assets or projects that will be
financed; the objective is to try matching the cash flows on the liability stream as closely
as possible to the cash flows on the asset stream;

22
- estimation of the tax savings that may accrue from using different financing vehicles and
weight the tax benefits against the costs of deviating from the optimal choices;
- examination of the influence that equity research analysts and ratings agency
views have on the choice of financing vehicles; instruments that are looked on favorably by
either or (better still) both groups will clearly be preferred to those that evoke strong
negative responses from one or both groups;
- finally, we allow for the possibility that firms may want to structure their financing to
reduce agency conflicts between stockholders and bondholders.
About the maturity of debt, firms can issue debt of varying maturities, ranging from very
short-term to very long-term. In making this choice they should first be guided by how long-
term the cash flows on their assets are. For instance, firms should not finance assets that
generate cash flows over the short term using 20 year debt. We have to examine how best
to assess the life of assets and liabilities and then we have to consider alternative
strategies to matching financing with asset cash flows.
The duration of an asset or liability is a weighted maturity of all the cash flows on that
asset or liability, where the weights are based on both the timing and the magnitude of the
cash flows. In general, larger and earlier cash flows are weighted more than smaller and
later cash flows. A simple measure of duration for a bond, for instance, can be computed
as follows:
N = maturity of the bond
t = when each coupon comes due
The duration of a bond will increase with the maturity of the bond and decrease with the
coupon rate on the bond.
Choosing the financing maturity, the basic idea is to match the duration of a firm’s assets
to the duration of its liabilities.
Rather than look at individual projects, you could consider the firm to be a portfolio of
projects; calculating the duration in case of more than one project could be more
complicated.
The firms have also to choice between a fixed rate or a floating rate. The interest rate on
floating rate debt varies from period to period and is linked to a specified short-term rate;
for instance, many floating rate bonds have coupon rates that are tied to the London
Interbank Borrowing Rate (LIBOR). The use of floating rate debt should be more prevalent
for firms that are uncertain about the duration of future projects and that have cash flows
that move with the inflation rate.
If cash flows move with inflation, increasing (decreasing) as inflation increases
(decreases), the debt should have a larger floating rate component.
Another important choice is the currency choice. If any of a firm’s assets or projects
creates cash flows denominated in a currency other than the one in which the equity is
denominated, currency risk exists. The liabilities of a firm can be issued in these
currencies to reduce the currency risk.
The forth problem is related to the choice between straight and convertible bonds. Straight
bonds create large interest payments and do not gain much value from the high growth
perceptions. Furthermore, they are likely to include covenants designed to protect the
bondholders, which restrict investment and future financing policy.

23
Convertible bonds, by contrast, create much lower interest payments, impose fewer
constraints, and gain value from higher growth perceptions. They are a good choice for
growth companies because of their cash flows characteristics.
Final consideration in designing securities is the provision of features intended to reduce
the agency conflicts between stockholders and bondholders. A potential solution is to
embed in the bond a call or put option:
- call options —> convertible bonds can also reduce the anxiety of bondholders about
equity investors investing in riskier projects and expropriating wealth, by allowing
bondholders to become stockholders if the stock price increases enough;
- put options —> more corporate bonds include embedded put options that allow
bondholders to put the bonds back at face value if the firm takes a specified action (such
as increasing leverage) or if its rating drops. Thus, bond investors would be protected in
the event of a downgrade.
To conclude, we can say that firms can change their debt ratios in four ways:
- they can recapitalize existing investments, using new debt to reduce equity or new
equity to retire debt;
- they can divest existing assets and use the cash to reduce equity or retire debt;
- they can invest in new projects and finance them disproportionately with debt or equity;
- finally, they can increase or decrease the proportion of their earnings that are returned
to stockholders in the form of dividends or stock buybacks.
Matching cash flows on financing to the cash flows on assets reduces default risk and
increases the debt capacity of firms. Applying this principle, long-term assets should be
financed with long-term debt, assets with cash flows that move with inflation should be
financed with floating rate debt, assets with cash flows in a foreign currency should be
financed with debt in the same currency, and assets with growing cash flows should be
financed with convertible debt.
Chapter 10:
For the dividend decision the starting point is the cashflow from operations; the dividend
decision can be represented with the following scheme (with the stock buybacks we are
selling our stocks, with the dividends not):

24
In Italy dividends are paid on an annual basis, in the United State they are paid every
quarter. Dividends in publicy traded firms are usually set by the board of directors and paid
out to stockholders a few weeks later.
There are several ways to classify dividends. First, they can be paid in cash or as
additional stocks; stock dividends increase the number of shares outstanding and
generally reduce the price per share. Second, the dividend can be a regular dividend
which is paid at regular intervals, or a special dividend which is paid in addition to the
regular dividend.
There are some empirical evidences about dividends:
- they are very stables year by year and their increases and their decreases are not very
commons;
- they tend to follow earnings but earnings don’t change our dividends policy;
- they are affected by tax laws;
- more and more firms are buying back stock rather than pay dividends —> the problem is
related by the higher volatility of the firms than the past years (companies prefer to
reduce the amount of dividends);
- there are a lot of differences across countries.
We can measure the dividend policy for a company in two ways:
- Dividend Payout Ratio = Dividends / Net Income —> it measures the percentage of
earnings that the company pays in dividends; if the net income is negative, the payout
ratio cannot be computed;
- Dividend Yield = Dividends per share / Stock price —> it measures the return that an
investor can make from dividends alone; it becomes part of the expected return on the
investment. The dividend yield is significant because it provides a measure of that
component of the total returns that comes from dividends, with the balance coming from
price appreciation (trade off between dividend yield and price appreciation).
Expected Return on Stock = Dividend Yield + Price Appreciation
The payout ratio is used in a number of different settings. It is used in valuation as a way
of estimating dividends in future periods, because most analysts estimate growth in
earnings rather than dividends. Second, the retention ratio, the proportion of the earnings
reinvested in the firm (Retention Ratio = 1 – Dividend Payout Ratio), is useful in estimating
future growth in earnings; firms with high retention ratios (low payout ratios) generally have
higher growth rates in earnings than firms with lower retention ratios (higher payout ratios).
Growth in earnings = ROE * (1 - payout ratio)

25
Third, the dividend payout ratio tends to follow the life cycle of the firm, starting at zero
when the firm is in high growth and gradually increasing as the firm matures and its growth
prospects decrease.
There is a strong relationship between the dividend policy and the life cycle of a firm (for
example, in the stage of start up the firm doesn’t have capacity to pay dividends; in the last
stage, the decline, the firm has an high capacity to pay dividends).
There are three schools of thought on dividends:
- if there are no tax disadvantages associated with dividends and companies can issue
stock, at no issuance cost, to raise equity, whenever needed —> dividends do not
matter, and dividend policy does not affect value;
- if dividends create a tax disadvantage for investors (relative to capital gains) —>
dividends are bad, and increasing dividends will reduce value;
- if dividends create a tax advantage for investors (relative to capital gains) and/or
stockholders like dividends —> dividends are good, and increasing dividends will
increase value.
If a company has excess cash, and few good investment opportunities (NPV>0), returning
money to stockholders (dividends or stock repurchases) is good; if a company does not
have excess cash, and/or has several good investment opportunities (NPV>0), returning
money to stockholders (dividends or stock repurchases) is bad.
For the first school of thought (dividends don’t matter) we study the Millen-Modigliani
Hypotesis; for them dividends do not affect value. If a firm's investment policies (and
hence cash flows) don't change, the value of the firm cannot change as it changes
dividends. If a firm pays more in dividends, it will have to issue new equity to fund the
same projects; by doing so, it will reduce expected price appreciation on the stock but it
will be offset by a higher dividend yield. If we ignore personal taxes, investors have to be
indifferent to receiving either dividends or capital gains. The underlying assumptions are
the following:
- there are no tax differences to investors between dividends and capital gains;
- if companies pay too much in cash, they can issue new stock, with no flotation costs or
signaling consequences, to replace this cash;
- if companies pay too little in dividends, they do not use the excess cash for bad projects
or acquisitions.
For the second school of thought (dividends are bad), we assume that you are the owner
of a stock that is approaching an ex-dividend day and you know that dollar dividend with
certainty. In addition,
assume that you have
owned the stock for
several years.
The cash flows from selling before ex-dividend day are: Pb-(Pb-P)tcg

26
The cash flows from selling after ex-dividend day are: Pa-(Pa-P)tcg +D(1-to)
Since the average investor should be indifferent between selling before the ex-dividend
day and selling after the ex-dividend day: Pb-(Pb -P)*tcg = Pa-(Pa-P)*tcg +D*(1-to)
Some basic algebra leads us to the following: (Pb-Pa)/D = (1-to)/(1-tcg)
The relationship between the price change on the ex-dividend day and the dollar dividend
will be determined by the difference between the tax rate on dividends and the tax rate on
capital gains for the typical investor in the stock.
There are two bad reasons for paying dividends:

- the bird in the hand fallacy —> dividends now are more certain than capital gains later;
hence dividends are more valuable than capital gains. Stocks that pay dividends will
therefore be more highly valued than stocks that do not.
The appropriate comparison should be between dividends today and price appreciation
today; the stock price drops on the ex-dividend day;
- we have excess cash this year —> the firm has excess cash on its hands this year, no
investment projects this year and wants to give the money back to stockholders.
If this is a one-time phenomenon, the firm has to consider future financing needs. The cost
of raising new financing in future years, especially by issuing new equity, can be
staggering.
For the third school of thought (dividends are good), the are three good reasons for paying
dividends:
- clientele effect —> the investors in your company like dividends;
- the signalling story —> dividends can be signals to the market that you believe that you
have good cash flow prospects in the future;
- the wealth appropriation story —> dividends are one way of transferring wealth from
lenders to equity investors (this is good for equity investors but bad for lenders).


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—> cash flow

—> r = cost of capital

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representation of the hurdle rate is:

Higher is the risk of the project higher is its risk premium.

Rendimento atteso di un’attività i —> Ke =

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provides an estimate of the actual risk premium earned by each factor.

The CAPM yields (produce) the following expected return:

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denominated in a currency where a default free entity exists)

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The determinants to estimate the company exposure to country risk are:

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A way of estimating Equity Risk Premium for countries:

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Equity betas and Leverage:

Firm value = Market Capital + Market Value of debt = E + D

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Cost of capital —>

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Cost of hybrids: there are two kinds of hybrids:

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FCFF = EBIT (1-t) + DEPRECIATION - NONCASH WORKING CAPITAL VARIATION -

FCFE = NET INCOME + DEPRECIATION - NON CASH WORKING CAPITAL VARIATION

cash flows from the project (including initial

We accept an investment if NPV > 0

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Non-cash working capital = Inventory + Accounts Receivable - Accounts Payable

Intuitively, money invested in inventory or in accounts receivable cannot be used

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r = project discount rate

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N = maturity of the bond

t = when each coupon comes due

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There are two bad reasons for paying dividends:

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